Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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13What is a hedge? According to the Webster's Dictionary, a hedge is (I) afence or boundary formed by a dense row of shrubs or low trees; or (2)a means of protection or defence as against financial loss. Hedging canreduce risk, but it seldom eliminates risk except that the hedging instrumentis exactly the same as the instrument being hedged. Perfect hedges are rare,as a trader put it, they can only be found in Japanese gardens.For example, a financial institution has just made a 5-year $50 million loanto one of its best borrowers. The interest rate on the loan is fixed at 7.0percent. The Chief Executive is quite concerned about the interest rate riskof this transaction. He did not want to make this deal because of theinterest rate risk. But he was afraid that he might lose this customer. Heasked the Treasurer to fully hedge the interest rate risk. The Treasurer inturn gave the assignment to a financial analyst.There are many ways to hedge this transaction, the young financial analystthinks. The simplest way is to enter into a 5-year interest rate swapexchanging the fixed rate payments of the loan to floating rate. Afterexamining the market swap rates, he finds that there is one problem: basedon the current implied forward curve, the bank will pay the counterparty6.0 percent for five years and receive floating payments based on a 3-monthLIBOR rate adjusted quarterly. The current 3-month LIBOR rate is 5.0percent. What this means is that at least for the first three months, thebank will have a negative net interest income on the swap - paying 6.0percent and receiving 5.0 percent. He knows that the bank is undertremendous pressure to improve its earning growth. A negative net interestincome on this swap certainly will not help.Hedging with Derivatives
The alternative is to buy an Interest rate cap. But the premium for a longtermcap is very expensive. In addition, 5-year caps are not that liquid.Another alternative, which the financial analyst thinks is the best, is to enterinto a pay-floating-receive-fixed swap. We call this a reverse swap, because itreverses a regular pay-fixed-receive-floating swap that is normally used for thepurpose of reducing interest rate risk. In this case, the bank will enter intoa swap to pay floating rates, currently at 5.0 percent adjusted quarterly basedon 3-month LIBOR rates, and receive a fixed rate of 6.0 percent. The beautyof this transaction is that the bank will have a positive net interest income atleast for the first three months. As long as 3-month LIBOR rates do not goup by more than one percent, which he does not think it will, the positive netinterest income will last for the duration of the transaction. Even if 3-rnonthLIBOR rates rise higher than 6.0 percent, the bank has already put somemoney in the pocket during the early part of the transaction, and hopefully itwill be enough to cover the future shortfall. So he checks the counterparty'scredit rating and enters into a $50 million reverse swap.The young financial analyst reports the transaction to the Treasurer. TheTreasurer happens to be very busy at that moment because the Dollar has justhit a 6-month high against the Yen, and the institution happens to have a largeopen position in US dollar. He does not have time to review the details ofthis swap transaction. On the other hand, it is a simple transaction. So heasks the financial analyst to inform the accounting department of the entiretransaction and he himself reports to the Chief Executive that the entire loanexposure is hedged and everything is all right. Both are happy because theinstitution has just earned a handsome profit in the currency market, and theinterest rate risk on the $50 million loan has been fully hedged.The above example is a real case with a slight modification. It happened ata large problem bank in California several years ago. The bank put a $300million pay-floating-receive-fixed swap on its book. At that time the yieldcurve was upward sloping, and this swap would increase the institution'sinterest rate exposure if interest rates rise. The bank's policy allowedHedging with Derivatives
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THE UNIVERSITY OF HONG KONGLIBRARIE
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VI- . .7 « i8^p ! ««^^OOSHSlVCJ
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Ever since derivatives took centre-
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denominator, value at risk, which c
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the kind of information that superv
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This book is a team effort of the H
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While most market participants defi
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of this investment is 6.32 percent
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Mathematically, the relation betwee
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$10,000. (For simplification of pre
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Hong Kong does go up and the HSI ri
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3OF ATHEPRICING OF A FORWARD CONTRA
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COST OF CARRYIn the above example,
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interest rate swap rates. From thes
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Borrowers, on the other hand, usual
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Again we use our method of having t
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ates, the forward rate for the peri
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5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79: OF AN11In the previous two chapters
Page 80 and 81: at-the-money option approaches its
Page 82 and 83: 12Mortgage-backed securities (MBS)
Page 84 and 85: NEGATIVE CONVEXITYFor MBS, there is
Page 86 and 87: MULTI-CLASSIn 1983, Freddie Mac int
Page 90 and 91: management to enter into swap and o
Page 92 and 93: transaction. For this criterion to
Page 94 and 95: CREDIT DEFAULT SWAPThe simplest for
Page 96 and 97: APPLICATION OF CREDIT DERIVATIVESYo
Page 98 and 99: in the US. Equally innovative, cred
Page 100 and 101: THE VARIANCE-COVARIANCE METHODThe t
Page 102 and 103: "cell" would have a cash flow expos
Page 104 and 105: Daily profit and loss ranked in asc
Page 106 and 107: of the market factor. Through this
Page 108 and 109: 3. Most value at risk models use hi
Page 110 and 111: 16ANDIn Chapter 5, we talked about
Page 112 and 113: price) of 9,000. For this transacti
Page 114 and 115: and the June 3-month futures rate i
Page 116 and 117: needs to take the necessary busines
Page 118 and 119: ief, the policies and procedures sh
Page 120 and 121: The derivatives industry can be com
Page 122 and 123: ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
Page 126 and 127: ensure that there is sufficient awa
Page 128 and 129: 15. Branches of foreign banks which
Page 130 and 131: 20. Where the institution considers
Page 132 and 133: RISK MEASUREMENT25. Having identifi
Page 134 and 135: ) the tendency of the relevant mark
Page 136 and 137: 38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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